Tips for Depreciating Tenant Leasehold Improvements, Construction and Renovation

What are Leasehold Improvements? Leasehold improvements (also referred to as “build-outs”) are structural changes or alterations to a leased space which are made by a tenant to make it useable for their specific business.  Some examples of leasehold improvements include: painting, lighting changes, partitioning, replacing flooring, ceilings, bathrooms, among many other things.

Some landlords pay for leasehold improvements to make their leases more appealing, and in these instances, the improvements belong to the landlord. The landlord would also have the right to deduct the expense of the improvements and their depreciation over time from his or her taxes.

What is Depreciation? Businesses must depreciate assets under the generally accepted accounting principles. Depreciation is the reduction of worth in an asset. As the company uses an asset, it moves the asset from the balance sheet to the income statement as a depreciation expense over the life of the asset.

What is Amortization? Amortization is the depreciation of intangible assets. Leasehold improvements refers to the costs incurred from making improvements to a rental property during the terms of the lease. Like depreciation, there are three main variables involved in determining leasehold improvements: the salvage value, the cost of the improvement and the useful life of the improvement.

What Does Furniture, Fixtures & Equipment (FF&E) Mean? Movable furniture, fixtures or other equipment that are have no permanent connection to the structure of a building or utilities. Examples of FF&E include desks, chairs, computers, electronic equipment, tables, bookcases and partitions.

You can amortize or depreciate qualified leasehold improvements that you make to the interior of a commercial building that you lease for your business. Examples include installing countertops, carpeting, or building new walls to create more offices. Qualified improvements don’t include things like installing an elevator or altering the building’s structural framework.

In most instances, these improvements are depreciated over a 15 year period. However, a 39-year period might be used in certain instances, such as where your business use of the property and improvement is less than 50% for the year.

Current Law – Through the end of 2011, tenant improvements are depreciated on a 15-year schedule. On January 1, 2012, this will return to a 39-year depreciation schedule unless Congress extends the law.

Depreciable property must generally meet these requirements:

1. Owned by the taxpayer;
2. Used in the business or income-producing activity;
3. Determinable useful life
4. Expected to last more than one year, and
5. Not otherwise excepted property, which includes:

  • Placed in service and disposed of in the same year,
  • Equipment used to build capital improvements,
  • Section 197 intangibles and
  • Certain term interests.

Examples of Recovery Periods

Asset Type Recovery Period (years)
Computers and peripherals,“Green Energy” equipment 5 years
Office furniture & fixtures 7 years
Land improvements (sidewalks, roads) 15 years
Qualified leasehold improvements 15 years
Nonresidential real property 39 years


“Bonus” Depreciation

• For eligible property placed in  service pre Sept. 9 2010, depreciation allowance equal to 50% (unless elected out)
• There is also a 100% special depreciation allowance on certain qualified property (see next slide) in 2010 & 2011 (after 9/8/10 and before 1/1/12).
• The special depreciation allowance equals 50% or 100% of the asset’s depreciable basis (cost or other basis less Section 179 expense deduction).
• Unlike 179 expense deduction, bonus depreciation can is only on the first year of service (e.g. new to “the world”).
•  100% Depreciation Allowance
– Placed in service date reminder – after 9/8/10 and before 1/1/12
– If you elect out of the 100% depreciation allowance for this property, it will not qualify for the 50% depreciation allowance.

What qualifies for bonus?

• New asset (“new” to anyone)
• MACRS property with an applicable recovery period of 20 years or less (generally, personal property)
(The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system in the United States)
• Certain computer software, or
• Qualified leasehold improvement property

Date Placed in Service

• Must be “in service” by 12/31/11
• Consider:
– Delivery and install
– Lead times
– Decision making time

Section 179 – Expensing of Capital Asset Purchases

• Section 179 allows a taxpayer to expense certain property in the year placed in service.
• To qualify, property must be used more than 50% in a trade or business and be acquired by purchase from an unrelated party.
• The Section 179 deduction maximum for property placed in service in 2010 and 2011 is $500,000.
• Total eligible purchases cannot exceed $2 million for 2010 or 2011 or phase-out kicks in.
• For 2012, 179 deduction reverts to $125,000 under present law.

Qualifying Property

• Automobiles.
• Computers.
• Machinery and equipment.
• Office equipment—copiers, typewriters, fax machines, etc.
• Office furniture—desks, chairs, file cabinets, book shelves, etc.
• Off-the-shelf computer software.
• Signs (if movable).
• Store counters.
• Testing equipment.

Dollar Limit on Section 179 Deduction

• The total cost of property that can be expensed for 2010 and 2011 is $500,000.
• For each dollar of Section 179 property placed in service during the year in excess of $2,000,000 (for 2010 and 2011), the $500,000 maximum deduction is reduced (but not below zero) by one dollar.
• If the total qualifying property placed in service during the year is $2,500,000 or more in 2010 or 2011, no Section 179 deduction is allowed.

Qualified Real Property & Section 179 Expense

• For 2010 and 2011, qualified real property, which is (1) qualified leasehold improvement property, (2) qualified restaurant property and (3) qualified retail improvement property is eligible for Section 179 expensing.
• Section 179 for qualified real property capped at $250,000 per year (leaving $250k for personal property) in 2010 and 2011.
• Unused amounts cannot be carried to a year after 2011 (effectively means deduction in 2011).

Section 179 –Business Income Limit

• Limited to the taxable income from active conduct of trade or business

• Computed without regard
– Section 179 deduction
– Net operating losses (NOLs)
– Deduction for self-employment taxes
– Unreimbursed employee business expenses

• Active trade or business income includes generally:
– Wages, salaries, tips and other compensation,
– Proprietorship (Schedule C or F) net income,
– Pass-through share of entity business income or loss related to active conduct of trade or business.

Section 179 Recapture

• The tax benefit derived from a Section 179 election must be recaptured as ordinary income if business use of the property falls to 50% or less during its MACRS recovery period. The basis of the asset is increased by the recaptured amount, which is computed as follows:

1. The amount originally deducted as Section 179 expense,
2. Minus: MACRS depreciation (from the year the property was placed in service through the current year) that would have been allowed on the Section 179 deduction claimed

What is Cost Segregation?

• Identifies personal property in the cost of buying or constructing (e.g. purchases, renovations, fitouts)

• Provides for faster depreciation deductions (e.g. increased cash flow from reducing current tax liability)

• IRS guidelines help determine which structural components are personal property for income tax

• States recognize this strategy and don’t generally tax “broken out” property for personal property tax

Cost Segregation –What to consider?

1. Is the property capable of being moved, and has it in fact been moved?

2. Is the property designed or constructed to remain permanently in place?

3. Are their circumstances which show that the property may have to be moved?

4. How substantial and time-consuming a job is removing the property?

5. How much damage will occur upon removal?

6. How is the property affixed to the land?

Cost Segregation Opportunities

• Large-scale leasehold improvements

• Renovations

• New construction

• Franchises (a “scale-able” study)

• Taxable entities or individuals with anticipated liability in current year and/or ability to get back refunds from prior years

Cost Segregation –Examples of Eligible Property

Reclassifying property. Personal property that might be included in the cost of real property, but could be broken out and depreciated under a shorter recovery period, includes:

• Cabinetry and counters • Movable partitions
• Carpet and padding • Music systems
• Decorative accent lighting • Portable fire extinguishers
• Decorative millwork • Public address systems
• Draperies and blinds • Refrigerators and stoves
• Emergency generator • Shelving and related millwork
• Emergency/security systems • Special exhaust systems
• Furniture • Special purpose enclosures
• Lockers • Washing machines and dryers
• Microwave ovens • Window air conditioning units

Energy Benefits –Green Building Deduction

• Section 179D – Green Building Deduction
– Benefit is up to $1.80 per square foot in a qualifying building if all systems qualify
– Extended through 2013 (available for systems as far back as 2006 with potential current-year benefit on prior-year projects)
– Eligible systems: Lighting, building envelope, heating/cooling
– Eligible taxpayers: building owners, certain tenants, and designers of energy systems (on gov’t buildings)
– IRS-approved software is specifically required

Energy Benefits – Federal Investment Credits

• 30% for investment in solar, fuel cells and “small wind”
• 10% for geothermal*, microturbines and combined heat/power
• Available through 12/31/16, but geothermal has no expiration date
• Reduces basis for depreciation
• Grants in lieu of credits available up to 12/31/11
More info (http://www.treasury.gov/initiatives/recovery/Pages/1603.aspx)

Please check with your financial advisor for specific tax advice.

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1 Comment on Tips for Depreciating Tenant Leasehold Improvements, Construction and Renovation

  1. I realize this is an older post, but I had a question about a landlord’s right to depreciate improvements that a tenant might make. For instance, if a tenant were to install LED lighting, would that be something the landlord could depreciate? My understanding is that the LED would still be owned by the tenant and could, conceivably, be moved or taken down by them. Is there any room for the landlord to depreciate this type of improvement that a tenant was making?

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  1. Take Advantage of Incentives That Can Offset Move Costs « Franklin Moves
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